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8/3/2019 Health Economics- Lecture Ch02
1/23
Microeconomic Tools
Dr. Katherine Sauer
Metropolitan State College of Denver
Health Economics
8/3/2019 Health Economics- Lecture Ch02
2/23
OutlineI. Consumer Theory
II. Elasticity
III. Theory of the Firm
Review on your own:
Production Possibilities Frontier
Supply and Demand
Functions and CurvesIndividual and Market Demands
Market Structure
Welfare Loss
8/3/2019 Health Economics- Lecture Ch02
3/23
I. Consumer Theory
examines how rational individuals make consumption
choices when faced with limited resources
2 parts: preferences and budget constraints
1. preferences
- assume consumer can rank goods
- ordinal not cardinal
utility: measure of satisfaction / happiness
marginal utility: extra utility from consuming
one more unit of the good
8/3/2019 Health Economics- Lecture Ch02
4/23
The Utility of Wealth
Utility
Wealth in dollars
Utility
MU
$1
8/3/2019 Health Economics- Lecture Ch02
5/23
Indifference Curves depict consumers preferences
over two goods
- downward sloping
- cannot cross
- bowed toward origin
U1
U2A
Y
X
E
D
F
C
B
Bundles F, D, A, E all
provide U1 of utility.
Bundle C contains the
same amount of Y as
D, but has more X
higher utility.
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U1
G
When you have a lotof good G, you are
willing to give some
up to get an additional
unit of A.
When you have less of
good G, you are not as
willing to give someup to get an additional
unit of A.A
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The slope of the indifference curve tells how willing to
give up good Y to get good X.- marginal rate of substitution (MRSX,Y)
U1
X
Y
Steep slope (willing to give up Y)
Flat slope (not as willing to give up Y)
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2. Budget Constraint
$20 for entertainment budgetmovie tickets cost $10
coffees cost $4
20 = 10M + 4C
20 10M = 4C5 2.5M = C
M
C
5
2
BC
C intercept is 5.
Slope is -2.5.
M intercept is5 2.5M = 0
5 = 2.5M
2 = M
8/3/2019 Health Economics- Lecture Ch02
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Budget constraints in general:
I = px
X + Py
Y
slope = -px/py
Y intercept = I/py
X intercept = I/px
Y = -(px/py)X + I/py
The slope of the budget constraint tells us the markets
rate of substitution between the goods.
8/3/2019 Health Economics- Lecture Ch02
10/23
3. Consumer Equilibrium
- a consumer wants to maximize satisfaction /
happiness but is constrained by their income
- a consumer will seek to be on the highest
indifference curve that they can afford
U1
U2
U3
D
B
C
A
At the optimum, the
slope of the budget
constraint is equal tothe slope of the
indifference curve.
Y
XX*
Y*
8/3/2019 Health Economics- Lecture Ch02
11/23
II. Elasticity
- measures the responsiveness of a variable to a
change in another variable
- the % change in a dependent variable from a
1% change in the independent variable
q,p = Q/Q
P/P
= Q . P
Q P= Q . P
P Q
q,I = Q . I
I Q
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q,p is always negative so use absolute value.
0 = q,p perfectly inelastic
0 < q,p < 1 inelastic
q,p = 1 unitary elastic
> q,p > 1 elastic = q,p perfectly elastic
q,I could be positive or negative.
> 0 normal good< 0 inferior good
= 0 no response
8/3/2019 Health Economics- Lecture Ch02
13/23
Price Elasticities
8/3/2019 Health Economics- Lecture Ch02
14/23
The impact of a cigarette tax:
S1
D1
Q1
S + tax
tax
D2
Q2
D3
Q3
Need a reliable
estimate ofelasticity to
predict what
happens to tax
revenues andthe level of
smoking.
Q
P
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15/23
III. The Firms Problem
1. production function
2. isoquants (same quantity)
3. isocost (same cost)
4. cost-minimization
8/3/2019 Health Economics- Lecture Ch02
16/23
1. Production Function
A production function
shows the maximum
sustainable output thatcan be obtained from
various combinations
of inputs, with existing
technology.
simple production
function only one input
8/3/2019 Health Economics- Lecture Ch02
17/23
A production function is typically expressed as
Q = f(X1, X2, X3, )
where X1, X2 and X3 represent inputs.
A particularly well-behaved production function is
the Cobb-Douglas production function:
Q = LK
8/3/2019 Health Economics- Lecture Ch02
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Example:
Suppose the capital is fixed
and labor is the variable
input.
Putting values of K and L
into a production function
will produce Q.
How are Marginal Product
and Average Product
calculated?
8/3/2019 Health Economics- Lecture Ch02
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2. Isoquants
- combinations of inputs that will produce a
certain level of output
L
K
Q=100
Negative slope means it is
possible to substitute
between inputs.- means MP is positive
Slope shows the
rate that K must
be given up touse one more unit
of L.
MRTSL,K
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3. Isocost
- a line which shows all the possible combinations
of inputs that result in the same total cost
TC = wL + rK
TC wL = rK
TC/r (w/r)L = K
K intercept is TC/r.
slope is w/r.
L intercept is TC/w.
K
TC/r
TC/w L
TC
8/3/2019 Health Economics- Lecture Ch02
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L
K
Q=100
4. CostMinimization Problem
- the firm would minimize costs by producing nothing
- the actual task is to minimize costssubject toproducing a certain level of output
TC
L*
K*
L* and K* are the cost
minimizing quantitiesof labor and capital to
use.
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The flipside of the Cost-Minimization problem is the
Output-Maximization problem:
Cost-Minimization
- minimize costs while producing a
certain level of output
Output-Maximization
- maximize the level of output produced
while only incurring a certain level of cost
8/3/2019 Health Economics- Lecture Ch02
23/23
Suppose your firm has $5000 to spend on production.
- you would be able to achieve a certain level of
output
If your firm had $10,000 to spend on production, youwould be able to achieve a higher level of output.
L
K
Q1TC = 5000
Q2
TC = 10000
Expansion path